Tuesday, September 29, 2009

Here follows PF2 Director Mark Froeba's written response to one of Senator Bennett's follow-up questions from the August 5th hearing on "Examining Proposals to Enhance the Regulation of Credit Rating Agencies."

SENATOR BENNETT: As we move forward on strengthening the regulation of credit rating agencies, it is important that we do not take any action to weaken pleading and liability standards of the Private Securities Litigation Reform Act of 1995. This Committee worked long and hard, and in a completely bipartisan fashion, to craft litigation that would help prevent abusive "strike" suits by trial lawyers. These suits benefitted no one but the lawyers who orchestrated these suits. This was a real problem then, and could become a real problem again if we dilute the current standard that applies to all market participants. Perpetrators of securities fraud, and those who act recklessly, can be sued under the law we passed in 1995.

Is there any justification for now altering this standard just for credit rating agencies?

MARK FROEBA: Yes, there is ample justification for altering the pleading and liability standards just for the credit rating agencies. Here are three arguments in support of changing these standards.

First, the major rating agencies have enjoyed the privilege of a government-sponsored monopoly for many years. In order to reduce the negative consequences of this monopoly, the government also encouraged competition among the agencies. There is overwhelming circumstantial evidence that the agencies responded by competing with each other not on price or efficiency or productivity or quality but, instead, on rating standards, revising rating methodologies and standards whenever necessary to build or maintain market share and revenue. Changing pleading and liability standards for the agencies would provide a key restraint should rating standards ever again end up in competitive free fall. Fear of liability will curb the appetite for market share, dampen the negative effects of competition, improve rating quality and, thereby, ultimately make lawsuits less necessary. The rating agencies, in exchange for continuing to enjoy the privilege of a government-sponsored monopoly, should be subjected to easier pleading and liability standards at least where litigants claim that bad ratings have injured them.

Second, when the rating agencies generate bad credit opinions, they have nothing at risk except their reputations. Other market participants involved in the transactions that failed in the subprime crisis, eg, investment banks, investors and collateral managers, all had some financial stake in these transactions. When these participants got it wrong, they were punished by financial losses, in some cases even to the point of bankruptcy. Having a significant financial risk is enough to warrant separate pleading and liability standards for these market participants. If reputation risk alone once provided the rating agencies with the same kind of incentives as financial risk, Enron taught them a new lesson. The bankruptcy of Enron within only days of losing its investment-grade ratings did severe damage to the reputation of the agencies but did little to hurt their business. In the aftermath of Enron, the rating agencies enjoyed some of their most profitable years ever. Thus, fear of reputation damage after Enron did nothing to check the ratings that caused the subprime crisis. It would be very difficult now to overstate the damage that the subprime crisis has done to the reputation of the rating agencies. If they all survive the current crisis unscathed – as seems almost certain -- they will be taught a lesson very dangerous to the world financial system: no matter how bad their ratings, no matter how damaged their reputations, they will not fail and the rating business will not go away because there is nowhere else for it to go. Without incentives that are far more potent than reputation risk, we cannot expect the rating agencies to reform themselves and impose greater quality and accuracy on their ratings.

Third, the rating agencies have long enjoyed near complete immunity from liability for bad ratings. This immunity is based upon an old line of cases that found the rating business -- assigning and reporting ratings – to be a form of journalism subject to free speech protections. More than forty years ago, this finding had some merit. The rating agencies assigned ratings to bonds and then reported all of their ratings in periodicals sold to subscriber/investors. Bond issuers paid the rating agencies nothing. However, the rating agencies largely abandoned this model forty years ago. The new model shifts the cost of the rating from subscriber/investors (eager for the most accurate rating) to bond issuers (eager for the highest rating). It is easy to see how the new model changed the rating agencies’ incentives. It is also difficult to imagine how real journalism could make a similar business-model switch. (It would be as if each newspaper story were commissioned by the subject of the story, based solely upon facts submitted by the subject, and published only upon the subject’s approval of the story and payment of a fee for its writing and publication.) Eventually, the courts will discover that the credit rating business is no longer anything like a form of journalism and should not be entitled to free speech protections. This will not happen overnight and may be a long and expensive process. In the meantime, the financial markets need help restoring their confidence in the quality and integrity of credit ratings assigned today. Changing the pleading and liability standards just for the agencies is an important first step in this process.

Thursday, September 24, 2009

It turns out I couldn't find a better antonym for "merrier" than "moroser."

But it is a grave and serious (both suggested antonyms) issue we're approaching today: the regulators' and market participants' aim to foster competition in the credit rating agency market. Just yesterday, various market participants and reporters expressed great delight at the NAIC's ruling to allow Realpoint LLC to rate portfolios of commercial mortgage-backed securities. (Separately, the NAIC is purportedly considering the viability of creating their own, not-for-profit rating agency.)

While we don't have anything whatsoever against Realpoint -- and while we certainly support the need for reform -- we would want regulators to tread this path carefully to avoid the creation of too many new credit rating agencies (CRAs or "NRSROs"). Remember, it was ratings competition that encouraged the decline in ratings quality in the first place, as the CRAs competed to win and maintain market share and revenue by altering their ratings standards.

We are not alone in this opinion. A former rating agency managing director submitted the following in prepared testimony to the House Oversight and Government Reform Committee:

“Senior management [at Moody's] still favors revenue generation over ratings quality and is willing to dismiss or silence those employees who disagree with these unwritten policies.” - Eric Kolchinsky

Competition as a concept is not necessarily a bad thing: for one it serves to bring down prices. We are not saying the "Big Three" CRA oligopoly should remain status quo. Nor are we saying that there should be a Big Three nor that it need remain Moody's, S&P and Fitch who comprise the Big Three. But we are saying that CRAs are not like hedge funds. Having three or five or ten accurate CRAs is worth a whole lot more than having 30 CRAs, irrespective of whether those 30 are accurate.

Why?

First, the recent years since Enron's failure have shown that regulating the CRAs is no mean feat. (Indeed the reforms proposed then were ineffective in buffering against this financial crisis.) It's going to be much more difficult to regulate an army of CRAs with different methodologies than to regulate only the currently existing ones. The SEC's website indicates that at least ten CRAs have already been granted NRSRO status.

Second, the creation of additional NRSROs places additional burden on the investor, who now has to familiarize herself with the slew of new methodologies.

Third, the CRAs were never competing on ratings cost anyway - they're competing on ratings standards (and historical performance to a limited degree). In other words, the less conservative approach might achieve a higher rating and win business. Now there will be more approaches to choose from. Thus, the availability of several alternatives only increases the problem of "ratings shopping," as issuers and structurers cast a wider net to achieve their ideal mix of (i) ratings quality/timeliness/service, (ii) ratings cost and (iii) minimal subordination level required to reach their target rating, in the case of structured finance securities. In the worst case scenario, thus, the rating chosen by the issuer, which typically seeks the highest rating, will be the most lenient measure available from the numerous CRAs. But this does nothing for the investor, who is usually best served by the most accurate rating. And the rating agencies are, after all, an investors service.

Fourth, the CRAs better fit the mould of regulator than that of market participant (buyer/seller). This financial crisis has brought upon us the realization that often having too many regulators can cause a problem: in the U.K. there is talk of the absorption of the FSA; in the U.S. the independent functionings of the OCC, OTS, and FDIC has resulted in various discussions -- especially with regional and community banks being able to swiftly switch between regulators -- which may result in one or more of them being folded into the SEC or the Fed, bodies proposing to take on further responsibilities going forward. Perhaps, then, we should be keeping tighter reins on the CRAs too and rather working towards creating fewer, manageable NRSROs with more meaningful responsibilities.

Monday, September 14, 2009

Anybody who’s seen the movie Charlie Wilson’s War will appreciate the fact that signs of economic improvement doesn’t mean we can take our foot off the peddle.

The film describes Charlie’s (ultimately successful) efforts in leading Congress to support Operation Cyclone, the largest-ever CIA covert operation, which supplied weapons to the Mujahideen during the Soviet war in Afghanistan. But the movie ends on a somber note, citing the U.S.’s premature exit in the epitaph to the film:

“These things happened. They were glorious and they changed the world ... and then we f----d up the endgame.” – Charlie Wilson

(The result: the Mujahideen eventually flowered into the Taliban and backed Osama bin Laden's war against the U.S.)

Our situation is hopefully not as drastic, but the point remains: even if we feel we have survived the crisis -- and that unemployment and default rates are leveling off -- we still need to implement the necessary reform measures to avoid the creation of a different monster in future.

With this in mind, we’ve put out our first paper on rating agency reform. The piece ends:

“The ultimate objective of this reform is to encourage financial market transparency and responsibility, from which liquidity will inevitably follow.”